Pages

Monday, 12 October 2015

The Question of Dividends as Passive Income

Recently, a friend directed me
to Giraffe Value’s blog post titled “Investing For Dividend Income(Passive) is a Fairytale!!!” The angle about dividends (that they cannot be considered passive income) brought forward by GV is refreshing indeed but I believe GV has
missed out some salient points and thus decided to offer an alternative
perspective in this topic by commenting in his blog. With GV's knowledge,
I herewith copy my comments (with very minor edits to make things more easily
understood) below. It may be helpful if you first read GV's article to understand his take on dividends.

With the CD & XD effect, are Dividends paid out still considered Passive Income to the investor?

Readers of this blog would have realized my reply are drawn out of and adheres closely to the "Business Perspective" section in my Stocks Investment Philosophy in which my investment framework is based on.

Also, as shown in my reply, I did agree with some points underscored
by GV. My intention here is to bring about healthy discussions in the hope of getting more clarity in this subject matter through insights and thoughts provided by readers and investors.

------------

Hi GV,

Good effort on your post. However, I wish to highlight an
alternative viewpoint that I personally feel provides a more inclusive and comprehensive
take about dividends. I believe the point of contention here is whether
dividends paid out is considered ‘passive income.’

First and foremost, I assume that your 2 questions are valid
in identifying whether passive income is involved. I would also add-on a 3rd
point to make the argument more robust:

1. Are you
richer after getting that dividend?

2. Would your
capital not get compromised after you receive the dividend?

3. Is the
money received passive (as opposed to the word ‘active’).

As a fundamental investor (I think you are one as well),
perhaps it is more insightful to look at holding the stock as being part-owners of the
business. To avoid complication, let’s just assume that we have 100% ownership
of a business. This view point can be easily extended to one who have partial
ownership of the business through buying its shares in the market.

As 100% owners of a profitable business, we employ officers
to add value to goods and services produced so as to generate income for us.
Every dollar earned from the business wholly belongs to the owners. In the
general sense, if earnings are $10M and beginning of year assets is $100M, the
company is now worth $110M. Going back to the 3 questions above, It is clear
that with full ownership of the business and by way of earnings generated, the
owners are now 1) $10M richer and obviously 2) their capital is not
compromised. Also, as the officers are the ones doing the hard work, we can
conclude that 3) it is ‘passive’ in nature. With this, we can say the earnings
are passive income to the owners.

The owners have the option to either keep the money in the
business as retained earnings or issue the earnings out as dividends. If say,
$5M of the earnings are released as dividends, the company is now worth $105M.
But because the owners own the business, their net worth is still $110M ($5M
dividends received plus $105M worth of business assets wholly owned by owners)
which necessarily means that in totality, their net worth still increased by
$10M. Is this $10M still considered passive? I argue so based on the 3
questions asked above. To the owners, these dividends are in actual fact just a
proxy to get hold of the passive earnings of the company.

Your take regarding the HDB is almost exactly the same as
the above scenario where it fulfils the 3 questions asked. Because in the stock
market, we are partial owners of the company, we tend to consider only the
dividends ($5M) and neglected the fact that the remaining $5M of the earnings
fully belonged to all shareholders as well (I believe your argument missed this
point too). So this $10M of earnings is akin to the rental income we get from a
fully owned HDB property.

Now let’s think from the standpoint of the stock investor.
Here, I would agree with you that an investor should consider both capital
appreciation and dividend return but I just want to highlight that dividends in
the investor's perspective are still passive income. Investor A purchase a
stock a $1 and price appreciates to $2. The company subsequently declares a
$0.50 dividends and share price proceeds to drop to $1.50 due to the XD effect.
Investor B purchases a stock at $1 and price appreciates to $2 with no
dividends declared. Both investors had a net gain of $1 from their investments.
Considering both realized and unrealized gain, it is clear that they are all
passive income to both investors. Having no net gain between Investor A and B
does not mean there are no passive income involved.

I also agree that your left pocket right pocket - zero sum
game theory makes perfect sense (but this does not mean dividends are not
passive income). Because dividends are
usually paid in liquid cash out of the company, it makes sense that stock price
should drop by the amount of dividends released. If not, we will find that the
net worth of the investor (which includes both dividends received as well as
ownership of the business) increase inexplicably. However, this effect is just
a logical stock market event to ensure that - assuming other things remaining
constant - the total amount of what owners received and what the business have
are the same before and after the event.

To conclude, CD-XD phenomenon is just an Event which fails
to explain that dividends received are not passive income but it does not
necessarily mean that dividends are not passive income. Viewed in the proper
way, the owner’s earnings are passive income and since dividends usually comes
from owner’s earnings, they are part of the passive income in every sense of
the word.

I got to your post because a friend referred it to me. Your
post must have generated strong interest as I understand that there are some
follow-ups in other financial blogs which mostly agree with your point that dividends
are not passive income. However, I feel that if we viewed this issue as a
whole, the logical (as well as intuitive) explanation contradicts the point
that dividends cannot be considered passive income. We've communicated some
time back and I know you are, like me, a keen learner of stock investments.
Hope to hear more about investments from you.

Secretinvestors

------------

PS: I appreciate that readers share their views about this in the comments section below. Also, GV gave an interesting reply to this comment. Readers can
refer to his blog article for that and decide for themselves which view point is more valid and logical.

Glad that you have a similar opinion as mine considering that quite a few have agreed to the other view point. I always feel it is important to have proper logic and thought before forming any view points on investments. The temptation to form premature theories without sufficient data and fact can be misleading and even dangerous in investments :) I hope that many more will contribute their thoughts and experience in this respect so that we can have a more complete picture about this topic.

Nice article you have there. I like your simple but practical investing mantra :) I believe you must also be doing well in your investments as well despite the recent fall.